It's still the most rewarding segment of the income trust family, as long as you don't mind a little risk.
Despite a generally awful October and energy prices that have dropped from record highs, the royalty trust sector is expected to generate good returns next year. Many of the trusts have boosted distributions to unitholders in recent months and have indicated further increases are coming soon.
BMO Nesbitt Burns analyst Gordon Tait says the royalty trust sector was down about 10 or 11 per cent in October. "Some of it [the decline] is because oil and gas prices are down," he says. "But October was a generally negative month. It's hard to tell how much was due to prices and how much was due to uncertainty, but we know both played a part."
However, Mr. Tait's model for assessing the performance of royalty trusts relies on estimates for oil and gas prices that are below current spot prices. "Even today our forecast uses prices below the spot market price, and we thought those prices were good."
And using a $57-a-barrel (U.S.) oil price this year, and $55 next year, Mr. Tait says, the outlook for the sector into next year is positive. Oil futures currently hover around $60, after coming close to $70 two months ago.
The royalty trust sector offers the highest yield of any income trust sector, as well as substantial unit price gains.
The Canadian Oil Sands Income Trust -- the largest in the S&P/TSX Capped Income Trust -- has seen its unit price rise more than 65 per cent so far this year, despite a 14-per-cent drop in the past month.
Of the 10 most heavily weighted trusts in the capped income trust index, seven are energy trusts. Only two of the 21 members of the S&P/TSX capped energy trust index have seen unit prices decline so far this year. Two-thirds of the index have shown double-digit per cent unit price increases in 2005.
However, royalty trusts also remain the most volatile segment of the income trust market, with trust performance almost entirely dictated by the fluctuating market prices of oil and gas. With the recent swing in commodity prices, there has been a decrease in capital flows to the sector. "There has been a bit of a slowdown," Mr. Tait says. "We're not seeing the same kind of buying activity."
Some industry players are also concerned that the royalty trust sector may not be immune from the consequences Ottawa's decision to take action on the amount of tax revenue lost because of the trust model. It's widely expected that any attempts to fix what is essentially seen by the government as a tax loophole will focus on the business trust sector, where many companies switch to the trust model primarily to avoid higher taxes.
However, Ross Freeman, a tax lawyer and head of Borden Ladner Gervais LLP's Calgary office, says tax changes will affect all trusts.
During a recent trip to Ottawa to lobby on behalf of energy companies and trusts, Mr. Freeman says he got the impression the government is likely to simultaneously impose a tax on trusts and lower the tax burden on corporations.
"[The government] had talked about eliminating the tax on corporate dividends -- about 25 per cent -- which would cost them about $3-billion a year," Mr. Freeman says. "They said that's too much. What they may do is reduce it to something like 15 per cent, and make up the difference by taxing trusts."
Mr. Freeman argues that royalty trusts increase productivity and any attempt to "kill trusts" by imposing excessive taxes on them would leave some junior energy companies out in the cold.
Because royalty trusts must distribute a large portion of their cash flow to attract and retain investors, the argument goes, they are not well-suited to start-up oil and gas companies, which must reinvest all their cash flow into exploration and production to build a reserve base.
The problem many junior companies have faced is lack of an exit strategy, Mr. Freeman said. Essentially, they weren't likely to be of interest to major players in the sector, nor were they likely to become majors themselves. However, the income trust system gives junior companies a host of new suitors, since those trusts are constantly looking for new sources of production.
This allows junior companies' former owners to start new companies, continuing a profitable cycle for them, their shareholders and royalty trust unitholders, Mr. Freeman says.
He argues that there have been hundreds of these transactions over the past few years, and extra taxation may put a stop to these deals and leave juniors in a position where "they're just going to be thinly traded and are going to get to a sort of no-man's land."
A decision on what to do about income trusts is likely to come out of Ottawa early next year. The issue already threatens to become an important political point, as the Conservative party -- which has a very strong presence in Calgary, the epicentre of the royalty trust earthquake -- is vehemently opposed to taxing trusts.
As far as royalty trust players are concerned, Mr. Freeman says, taxation is the biggest threat on the horizon. "There's no other issue that comes close to this."
Canadian Oil Sands Income Trust is one of the most vocal opponents of taxation, largely because the biggest trust in the country by market capitalization has a lot at stake.
"Our CEO has been very active in lobbying the government," COS director of investor relations Siren Fisekci says. "We feel this is something that affects us, and it's important to let the government know they shouldn't tinker with [taxes] to a significant degree."
A decision early next year would coincide with the beginning of a boost in COS's production capacity. The trust, which owns 35.5 per cent of Syncrude Canada Ltd., will see production rise to almost 100,000 barrels a day from about 76,000, a move that is widely expected to result in more distribution increases to unitholders.
But COS also faces another regulatory challenge that's seen more often in the royalty trust sector than any other trust segment: foreign ownership. As of Oct. 13, the trust's geographical data showed 47-per-cent non-Canadian-resident ownership, closing in on the trust's limit of 49 per cent.
Once COS hits that limit, Ms. Fisekci says, it will stop selling units to non-residents and that restrict its access to market capital. However, she adds, the restriction is not as big an issue since COS is already finished with the expansion that will boost capacity next year.
The foreign ownership issue is still up in the air. Last year, Ottawa proposed a cap on all trusts. The government later backed off, but did not say the issue is dead.
The royalty trust sector has the highest level of foreign ownership of any income trust segment.
Unlike COS, which follows a provision in the Income Tax Act that restricts foreign ownership, most trusts operate under another clause in the act that theoretically provides exemption. There may be some clarification on the foreign ownership issue when Ottawa decides on taxation.
However, even with the uncertainty surrounding taxation, ownership and commodity prices, Mr. Tait says, the sector still looks good fundamentally.
"The multiples are down, the payout ratios are very conservative, they have very strong balance sheets, they're generating lots of cash," he says. "The group looks on very firm ground from a valuation standpoint."
© The Globe and Mail
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